Summer Heat

by Larry Hatheway | July 26th, 2022

After a miserable first half of 2022, investors are looking forward to August at the beach. And why not? As bad as stock and bond markets have been in the first half of 2022, the arrival of the ‘dog days’ of summer comes with record scorching heat across most of North America, the British Isles and Europe. There is no shortage of reasons to get away for a respite from the summer heat.

But before investors pack their summer gear, they’ve got another big week to endure. The coming five days are stuffed with key economic data, policy events, earnings reports, and potential pitfalls. For markets, the final week of July could prove to be the most decisive week of the year. And it might even portend an ugly August, ruining many a vacation, as has often been the case.

Here’s what is on tap.

On Wednesday, the Federal Reserve will announce its latest policy decision, with the consensus of economists anticipating another 75-basis point rate hike, lifting the Fed Funds rate to 2.5%. More important will be the Federal Open Market Committee (FOMC) statement and Chairman Powell’s ensuing press conference. Market participants will scrutinize the Fed’s language for signs that the US central bank may slow the pace of its tightening later this year by now acknowledging that growth is weakening and that long-term inflation expectations remain well-behaved.

Indeed, that is just what the bond market now anticipates. Last week, the yield on the two-year US Treasury note plunged more than a quarter of a point, reflecting the anticipation that the Fed will adopt a more gradual tightening pace over the remainder of this year and into 2023. But if the Fed or the upcoming economic data don’t confirm that view, markets could again be roiled.

A lot rides on the upcoming economic data. Before Wednesday’s Fed meeting, investors will digest numbers on home prices, new and pending home sales, mortgage applications, and US durable goods orders. Those figures are apt to show a weakening of residential and non-residential investment in the US economy. After the Fed’s decision comes Thursday’s release of preliminary Q2 US GDP, which is expected to confirm a slowing of US final demand. Investors will also be interested in the quarterly and monthly core personal consumption expenditures inflation measures released on Thursday and Friday, respectively. Jobless claims (which have recently edged higher) and the July employment report (next week) will also be closely followed by market participants.

In short, just as investors head off to their summer holidays, consensus expectations for peak inflation and slowing economic activity could be confirmed — or not. It may be, for instance, that inflation will remain stubbornly high. Or recession fears might emerge if demand or employment prove weaker than expected. The key point is that with the market now expecting a moderately weaker growth and slowing inflation, anything else will be a disappointment.

European macroeconomic data will also be in the spotlight, with a weak German IFO release expected on Monday, which could portend an arriving Eurozone recession. Equally important will be the German inflation data on Thursday. Here, too, investors must reckon with a worst-case scenario of stubbornly high inflation, given soaring natural gas prices and higher import prices owing to a weak euro. Eurozone stagflation would test the ECB’s new-found resolve to tighten monetary policy. It could also compound pressures on Italy’s bond market, which were unleashed last week by Prime Minister Draghi’s resignation. The ECB’s Transmission Protection Instrument (TPI) — which some wags dub ‘Trying to Protect Italy’ — could face an early test of its viability.

Finally, the coming five days mark the single biggest week of Q2 corporate earnings releases, with 175 S&P500 members reporting, including tech giants Alphabet, Amazon, Apple, Meta, and Microsoft. With about of fifth of S&P500 companies having already reported, earnings and revenue surprises are lagging five- and ten-year averages, with even larger disappointments if the energy sector is excluded. Also, as we have noted in various recent commentaries, the consensus of analysts’ earnings expectations for the second half of 2022 remains wildly optimistic relative to what will occur if US growth grinds to a standstill and the Eurozone slips into recession.

In sum, recent market moves suggest that investors are anticipating smooth sailing ahead. Growth is expected to weaken enough to curb inflation, but not so much as to erode corporate profitability. Central banks are expected to tighten prudently, but not excessively. Lockdowns in China, political uncertainty in Italy, or Russia’s invasion of Ukraine are not expected to further harm growth nor boost inflation again. Put another way, investors have chosen, like Goldilocks, a bowl of porridge that is not too hot, and not too cold — just right.

Against that backdrop, investors will soon be rummaging their closets for sandals and beachwear. They can (and should) pack plenty of refreshments and extra sunblock to protect them from the scorching sun. But try as they might, they cannot mitigate the significant risks that remain for the global economy political economy and capital markets. Even the coolest sea breezes may not provide much refuge from the heat of summer.

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